The Behaviorist: On Wall Street Things Can Fall Up

June 15, 2010

In his IndexUniverse.com column “The Behaviorist,” a San Francisco Bay Area financial adviser laments how the search for immutable laws of finance will forever be fruitless, as an endless stream of bubbles and blowups will always show us.

During IndexUniverse.com’s excellent April 6 webinar, Rethinking Asset Allocation, Dave Nadig described a range of asset allocation software “from the shockingly simplistic to the insanely complex.” He went on to point out that these are only tools, advising listeners to “drive the model, don’t let it drive you.”

Kent GrealishIt got me thinking about the ongoing search to discover the “laws” that control the securities markets—the belief in the existence of hard and fast rules, similar to the laws of physics, which explain how the financial world really works.

Wanting to know the unknowable is an integral part of our human nature. We obsessively crave certainty even when it’s clearly impossible to obtain. This is particularly true when it comes to the securities markets. After all, didn’t Wall Street hire actual “rocket scientists” and physicists such as Fischer Black to try to value options and mortgage-backed securities? Now we have a whole generation of “quants” trying to apply the ordered world of mathematics to the chaos of Wall Street.

Elegant models such as Black-Scholes notwithstanding, the pursuit of the stock market equivalent of the laws of gravity or thermodynamics is, like the quest for the Holy Grail, a noble enterprise doomed to failure. If that weren’t so, Long-Term Capital Management would now own the world and wouldn’t have self-destructed and nearly taken the global financial system with it back in 1998.

The problem isn’t the attempt to completely understand what must, at least to some degree, remain a mystery. As Robert Browning observed, “Man’s reach should exceed his grasp.”

It’s when practitioners start believing too much in their models that real problems arise. Given man’s inherent overconfidence (not to mention pride), it’s easy to forget that a model’s predictive ability is entirely dependent on the validity of its supporting assumptions. Given a long enough string of successful outcomes, you have all that’s necessary to make the leap of faith from conjecture to belief. The decision to go “all in” comes soon after that point, but well before the Black Swan event arrives to blow everything up.

But by far the greatest threat surrounding these supposedly immutable “laws” of finance isn’t that they ultimately prove false. The biggest risk is the perverse way in which they can suddenly operate in reverse. The laws of physics will always ensure that gravity works in one direction 100 percent of the time, but in the securities markets, things sometimes fall up, and, when they do, they can destroy an otherwise elegant theory along with your once-profitable portfolio.



Kent
Grealish is a financial adviser with San Bruno, Calif.-based Quacera Capital Management LLC. Grealish, an accredited investment fiduciary® (AIF®) and a certified financial plannerTM (CFP®), provides services on an hourly, fee-only basis.

 

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